Point A defines the boundaries of an Edgeworth box diagram of consumption. That is, the same mix of products that are produced at point A, can be consumed by the two consumers in this simple economy. The consumers' relative preferences are shown by the indifference curves inside the Edgeworth box. At point B the marginal rate of substitution (MRS) is equal to 2, while at point C the marginal rate of substitution is equal to 3. Only at point B is consumption in balance with production (MRS=MRT). The curve 0BCA (often called the contract curve) inside the Edgeworth box defines the locus of points of efficiency in consumption (MRS1=MRS 2). As we move along the curve, we are changing the mix of goods X and Y that individuals 1 and 2 choose to consume. The utility data associated with each point on this curve can be used to create utility functions.
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( 3.1 / 29 )The basic welfare economics problem is to find the theoretical maximum of a social welfare function, subject to various constraints such as the state of technology in production, available natural resources, national infrastructure, and behavoural constraints such as consumer utility maximization and producer profit maximization. In the simplest possible economy this can be done by simultaneously solving seven equations. This simple economy would have only two consumers (consumer 1 and consumer 2), only two products (product X and product Y), and only two factors of production going into these products (labour (L) and capital (K)). The model can be stated as:
maximize social welfare: W=f(U1 U2) subject to the following set of constraints:
K = Kx + Ky (The amount of capital used in the production of goods X and Y)
L = Lx + Ly (The amount of labour used in the production of goods X and Y)
X = X(Kx Lx) (The production function for product X)
Y = Y(Ky Ly) (The production function for product Y)
U1 = U1(X1 Y1) (The preferences of consumer 1)
U2 = U2(X2 Y2) (The preferences of consumer 2)
The solution to this problem yields a Pareto optimum. In a more realistic example of millions of consumers, millions of products, and several factors of production, the math gets more complicated.
Also, finding a solution to an abstract function does not directly yield a policy recommendation! In other words, solving an equation does not solve social problems. However, a model like the one above can be viewed as an argument that solving a social problem (like achieving a Pareto-optimal distribution of wealth) is at least theoretically possible.
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( 3 / 35 )Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution associated with it. It attempts to maximize the level of social welfare by examining the economic activities of the individuals that comprise society.
Welfare economics is concerned with the welfare of individuals, as opposed to groups, communities, or societies because it assumes that the individual is the basic unit of measurement. It also assumes that individuals are the best judges of their own welfare, that people prefer greater welfare to less welfare, and that welfare can be adequately measured either in monetary terms or as a relative preference.
Social welfare refers to the overall utilitarian state of society. It is often defined as the summation of the welfare of all the individuals in the society. Welfare can be measured either cardinally in terms of dollars or "utils", or measured ordinally in terms of relative utility. The cardinal method is seldom used today because of aggregation problems that make the accuracy of the method doubtful, as well as strong underlying assumptions.
There are two sides to welfare economics: economic efficiency and income distribution. Economic efficiency is largely positive and deals with the "size of the pie". Income distribution is much more normative and deals with "dividing up the pie".
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